Are Dividend-Paying Stocks a Good Substitute for Bonds?

I received lots of thoughtful responses to my recent article asserting that many pre-retirees are too heavy on stocks.

One comment that kept coming up went something like this: Don’t dividend-paying stocks fulfill a similar role to bonds?

The answer, I think, is nuanced. While retirees might use dividend-paying stocks or funds to supplant a portion of their bond exposure, I get nervous when retirees use them to take the place of bonds altogether. And I think retirees should get nervous, too.

What's Not to Like? For retirees who would like to receive a component of their cash flows from organic income production, the appeal of dividend-payers is obvious. Although bond yields have come up over the past few years, yields from dividend-paying stocks remain competitive. While the S&P 500 barely pays out 2%, the FTSE High Dividend Yield Index, composed of the higher-yielding half of U.S. dividend-paying stocks, yields about 3% today--right in line with the yield of the Bloomberg Barclays Aggregate Bond Index. Dividend-paying companies also have the opportunity to increase the dividends they pay out to shareholders; with a bond, the yield you see is the yield you get.

Dividends have composed a huge share of the market’s return over time, so it stands to reason that dividend-paying stocks should be a meaningful component of every investor’s portfolio--income-oriented or otherwise. And the ability to pay a dividend says a lot about a company's financial wherewithal and overall quality. Of the dividend-paying stocks in Morningstar’s database, for example, 42% earn a financial health grade of B or better; just 20% of non-dividend-payers do. Yielders are also more likely to have sustainable competitive advantages: 43% of firms that pay out dividends have a narrow or wide economic moat, whereas just 29% of non-dividend-payers do.

In addition, yielders look more attractive than non-yielders when their valuations are factored in, a valuable attribute in a market that many view as overextended. Fully 23% of companies that pay dividends earn Morningstar Ratings of 4 or 5 stars currently, whereas just 11% of non-yielders do. That’s a reflection of the fact that growth companies are less likely to pay dividends than value and blend names, and growth stocks have trumped value over the past decade.

The currently favorable tax treatment of dividend income also belongs on the list of what's right with dividend-payers. Qualified dividend income is currently taxed at just 15% for single filers with incomes of less than $434,550 ($488,850 for married couples filing jointly). Meanwhile, single filers with incomes below $39,375 and married couples filing jointly with incomes below $78,750 pay no taxes on dividends, assuming their incomes stay below those thresholds. Bond income, by contrast, is taxed at your ordinary income tax rate.

'Bad Losses in Bad Times' That's a long way of saying that dividend-payers have much to recommend them. But the obvious counterpoint is that the volatility profile of even a well-diversified basket of dividend-payers is much higher than bonds. Over the past 15 years, a period that captures the financial crisis, the S&P High Yield Dividend Aristocrats Index has a standard deviation of 13, versus just over 3 for the Bloomberg Barclays Aggregate Index.

But many dividend aficionados tell me they’re not so worried about volatility or even real losses. They feel comfortable with dividend-payers because they deliver the income they’re looking for, plain and simple. If stocks increase in value as they collect that income, great; if they don’t, the income will still be there and the stocks will probably recover eventually.

But I keep coming back to asset-allocation guru Bill Bernstein and his ultra-intuitive definition of risk--“bad losses in bad times.” What if something happens to dividend-payers’ income production at the same time the portfolio drops in value? In that case, the dividend-oriented retiree’s only choice may be to drop spending, venture into potentially riskier securities to help boost yield, or sell depreciated equities. From that standpoint, dividend-paying equities seem quite risky as a stand-alone retirement portfolio.

The financial crisis provides a perfect, albeit somewhat exaggerated, illustration of the risks of relying exclusively on dividend-payers for needed cash flows in retirement. Many banks, which had previously been a reliable source of dividends in the years leading up to the crisis, slashed their dividends because of business pressures. Banks’ share prices, already under pressure with the rest of the U.S. market, tumbled because of the dividend cuts. SPDR S&P Bank ETF KBE, for example, shed more than 80% of its value from peak to trough during the financial crisis, versus a 56% cumulative drop for the S&P 500.

For shareholders who were relying on dividends from their bank stocks, the dividend cuts and subsequent price drops were a double whammy. Not only did a source of their in-retirement cash flows dry up as yields were cut, but selling stocks to meet cash flows wasn’t a viable option either. In other words, bank-focused dividend investors experienced bad losses in bad times.

Of course, that’s a worst-case scenario. Most sensible investors assemble dividend-payers from a host of different sectors, not just one. And indeed, most well-diversified dividend-focused funds and exchange-traded funds experienced losses that were no worse than the S&P 500 experienced during the financial crisis. (Dividend-growth funds like Vanguard Dividend Growth VDIGX and Vanguard Dividend Appreciation VDAIX/and ETF VIG performed even better, but their yields aren’t higher than the broad market’s.) Moreover, the economy seems to be in decent shape, and there aren’t any obvious storm clouds hovering over any one particular pocket of the dividend-paying universe.

Getting It Done Nonetheless, the experience of bank-stock investors during the financial crisis points to the value of building a contingency plan around a portfolio of dividend-paying investments. In a worst-case scenario in which dividend cuts occur around the same time those dividend-payers' share prices drop, the retiree has another source of assets he or she can tap to meet cash flow needs.

While dividend-focused retirees needn’t necessarily hold a full 10 years’ worth of cash flows in cash and bonds, as is the case with my model bucket portfolios, holding at least a stake in such safe securities alongside the dividend-payers is a sensible practice. (How much depends on the retiree’s own risk preferences.)

And if dividend-payers are going to be a central component of your retirement cash flow plan, I’d argue for keeping the composition of the nonequity portfolio on the high-quality, low-risk side. Because the idea of this portion of the portfolio is to hold its ground and possibly even gain if the dividend-payers encounter troubled times, focusing on cash as well as high-quality short- and intermediate-term bond funds helps further that aim. Such bonds’ yields aren’t particularly impressive right now, but they’re apt to be a reliable source of ballast in periods of equity-market weakness.

Finally, diversifying the risks of the dividend-paying stock portion of the portfolio is also key. While investors with very large portfolios may well choose to select individual dividend-paying equities, dividend-focused mutual funds and ETFs can provide a lot of diversification in a single shot. The key is to keep costs way down to ensure that more of the yield flows through to you rather than the fund company.